THE BASIS POINT

How Does The Government Get To Rates to 4.5%?

By now everyone’s heard about the Fed’s quantitative rate easing plan. The announcement that the Fed will buy $500b in Fannie/Freddie bonds to drive yields down caused rates to drop by about .625%. But the Fed hasn’t even started purchasing the mortgage bonds yet because they need to raise money to do so. Now the stories floating around are about how Treasury is trying to:

encourage banks to issue new mortgages at lower rates by offering to purchase securities underpinning the loans at a price equivalent to the 4.5% rate. The Treasury would fund the purchases by issuing Treasury debt at 3%, suggesting the government could make a profit on the difference.

We’re not sure yet if the two things are separate so we’re trying to reconcile the two strategies. Here’s our understanding of how this will work:

Treasury issues 30 year bonds at current 30yr yield levels of about 3%. They (or the Fed) buy existing 5.5% and 5% 30yr Fannie/Freddie bonds until they drive those yields low enough to where banks can issue mortgages at around 4.5%. Then when new 4.5% coupon bonds are issued (based on new pools of underlying mortgages at those rates), the government buys those too to support that general yield level. The positive spread for Treasury/Fed (and taxpayers) versus Treasuries is about 1.5%, assuming that the mortgage bonds return to more acceptable default levels at those rates. The theory is that 4.5% range rates on long-term fixed loans stop the foreclosure spiral that is putting extra downward pressure on home prices, and therefore defaults normalize which makes those new Fannie/Freddie bonds a good credit risk and makes the 1.5% spread more plausible.

Certainly a lot of theory. And this is simplified drastically. We don’t fully know how it’s going to work (and frankly, the world’s smartest people don’t either), but this is the guess for now. More to come.

In the meantime, the consumer is going to see some very attractive rates.